View the original article in the Triangle Business Journal by clicking here.
The old adage ”it’s lonely at the top” applies nowhere better than to running a private company, where CEOs make daily decisions about disciplines in which they have no background.
Having worked with over 200 private-company owners over the past 25 years, it is my observation that the most underutilized resource for private companies is a “real” board of directors. If you want to maximize the potential of a company and fully enjoy the experience of running a business, owners need to surround themselves with a seasoned, diverse compliment of business minds that meet on a regular basis.
Most business owners have complete autonomy. In fact, the primary reason many started their own company is that they don’t want anyone looking over their shoulder. However, not only is running a business too complex for any single individual, it is no fun to make decisions in a vacuum over an extended time period.
Business owners succeed because they are really good at something. It might be science, medicine, manufacturing or sales. But that something is rarely business. The Achilles heel of most business owners is that they don’t know what they don’t know.
It is not an admission of failure to acknowledge that you need help making key business decisions. In the 1980s the board of Coca-Cola, one of America’s most successful companies, was comprised mostly of marketing experts, with some lawyers and doctors who were buddies of the CEO thrown in. Coke’s stock had been dormant for years. Roberto Goizueta emerged from an unlikely background–head of the R&D department–to take the helm at Coke. The chemist questioned everything about the business despite its great success, and he reconstituted Coke’s board with experts who knew what he didn’t know. Over the next decade Coke stock grew ten-fold, dwarfing the S&P 500, largely the result of implementing new financial strategies his prior board had never considered. Today Emory University’s business school is named after Mr. Goizueta, because he knew what he didn’t know and built a board to supplement his skill set.
What Should Your Board Look Like?
The key to constructing a successful board is to assemble a diverse set of business skills that are complimentary, not redundant. You need at least one person who has significant knowledge of corporate governance. Unless there are people in the room who know what a board is supposed to do and how boards function most effectively, you will have the blind leading the blind.
You also need someone with specific industry knowledge, who knows what is going on in your competitive landscape.
You need an expert in finance. Most private-company CFOs are really controllers. You should have a board member that knows all aspects of the capital markets and has worked on transactions. Even if you have no immediate need to raise equity, borrow money, make an acquisition or sell your business, some day you will.
The backgrounds of the other board members depend on your business and your personal skill set. Recruit directors whose competencies are in areas in which you are the weakest.
Except in rare instances, employees should not serve on the board. They can attend board meetings to make presentations and contribute to dialogue, but there should be times when the directors are free to discuss management issues without management (except the owner) present.
Likewise, every company should have a competent lawyer and accountant, but they should not be on the board. Public companies are prohibited from selecting their accountant and lawyer to serve on the board for a reason. They have a different role as paid advisors.
Your board should meet at least four times a year. Any less, and it is impossible for directors to get to know the company and its management team, limiting their ability to offer insightful advice.
While it may be counter-intuitive, the best boards have an even number of members. You never want a board decision determined by a single vote. If a solid majority of the board is not convinced a path is the right one, you shouldn’t go down it.
Your directors should receive some compensation. The amount and form depends on the size of your business, its financial resources and its stage of development. If you have the right directors, their sage advice is probably worth many multiples of whatever you pay them.
Consult your board between board meetings. Directors are a resource 365 days a year.
Surveys show that private companies with true boards outperform those without. What is not commonly known, though, is that business owners who have a true board of directors enjoy their jobs more—it is not so lonely at the top.
View the original article in The News and Observer by clicking here.
Most of the people I encounter in the business community will tell you that they are not fans of Donald Trump as a person, but they agree with most of his policies including lower taxes, less regulation, beefed up national security, and greater individual liberty. And they are impressed with his progress on all these fronts.
But to win the next election will require something more than the standard Republican playbook to capture independent voters.
While there are a few Democrats who will not be running for president in 2020, just about everyone on the left who is has started floating policy ideas they hope will differentiate them from the pack. This is a good thing. Republicans should listen with an open mind and come up with some fresh ideas of their own.
Despite her progressive hubris, Elizabeth Warren may be the smartest of the liberal candidates.One of her foundational economic ideas is to radically alter American corporate governance by placing workers on the boards of public companies. Since I headed corporate governance policy under Bush 41, and teach the subject at UNC’s Kenan-Flagler Business School , I feel a duty to weigh in.
Though Warren’s proposal is antithetical to America’s business culture, which considers the owners of companies the ones to whom the corporation should be accountable, I agree with her premise that corporate stakeholders are too often ignored by profit-obsessed CEOs.
The financial goal of a company is not to maximize near-term profits, as commonly believed; it is to maximize long-term shareholder value. Those are often very different objectives. Try to explain Tesla’s stock price with quarterly earnings. To maximize sustainable shareholder value, a company must pay attention to and seek buy-in from all its stakeholders, including workers, customers, suppliers, and the community; as well as respect the environment. The current generation of CEOs was not taught this in business school, and too few of them practice it. If a decision does not show a positive cash flow on a spreadsheet, it is rarely implemented. But many sound business decisions cannot be easily quantified.
My favorite business role model is a company whose motto is: “People over Profits.” This company pays its employees above the industry average and invests far more in worker training than its peers. It provides customer service radically superior to any of its competitors. It encourages store managers to become involved in their local community. It has even innovated a process to recycle Styrofoam cups. In an industry with grueling work schedules, this fast food company is closed on Sundays to allow its employees a day of rest, and time to attend church and/or be with their family.
No traditional MBA course would teach such a business model, in which a company embraces all its stakeholders at the apparent expense of the bottom line. So how does this company’s financial performance compare to its profit-obsessed competitors?
Chick-fil-A generates an astonishing 50 percent more revenues per store than any other fast food company, including McDonald’s, Wendy’s, and Hardees. And that is in six, not seven, days a week.The shareholders are very handsomely rewarded by the company serving its other stakeholders. It is a virtuous cycle.
Capitalism is increasingly vilified by liberal candidates. Only congress is less respected by the general public than big business. With the likes of Wells Fargo, Facebook, and big pharma fleecing stakeholders for short-term economic gain, many corporations deserve their sullied reputations. If they fail to practice a more enlightened form of capitalism, they may face a new sheriff in town in 2020.
Written by Michael Jacobs and Anil Shivdasani. Click here to see the original publication in the Harvard Business Review.
With trillions of dollars in cash sitting on their balance sheets, corporations have never had so much money. How executives choose to invest that massive amount of capital will drive corporate strategies and determine their companies’ competitiveness for the next decade and beyond. And in the short term, today’s capital budgeting decisions will influence the developed world’s chronic unemployment situation and tepid economic recovery.
Although investment opportunities vary dramatically across companies and industries, one would expect the process of evaluating financial returns on investments to be fairly uniform. After all, business schools teach more or less the same evaluation techniques. It’s no surprise, then, that in a survey conducted by the Association for Financial Professionals (AFP), 80% of more than 300 respondents—and 90% of those with over $1 billion in revenues—use discounted cash-flow analyses. Such analyses rely on free-cash-flow projections to estimate the value of an investment to a firm, discounted by the cost of capital (defined as the weighted average of the costs of debt and equity). To estimate their cost of equity, about 90% of the respondents use the capital asset pricing model (CAPM), which quantifies the return required by an investment on the basis of the associated risk.
But that is where the consensus ends. The AFP asked its global membership, comprising about 15,000 top financial officers, what assumptions they use in their financial models to quantify investment opportunities. Remarkably, no question received the same answer from a majority of the more than 300 respondents, 79% of whom are in the U.S. or Canada. (See the exhibit “Dangerous Assumptions.”)
That’s a big problem, because assumptions about the costs of equity and debt, overall and for individual projects, profoundly affect both the type and the value of the investments a company makes. Expectations about returns determine not only what projects managers will and will not invest in, but also whether the company succeeds financially.
Say, for instance, an investment of $20 million in a new project promises to produce positive annual cash flows of $3.25 million for 10 years. If the cost of capital is 10%, the net present value of the project (the value of the future cash flows discounted at that 10%, minus the $20 million investment) is essentially break-even—in effect, a coin-toss decision. If the company has underestimated its capital cost by 100 basis points (1%) and assumes a capital cost of 9%, the project shows a net present value of nearly $1 million—a flashing green light. But if the company assumes that its capital cost is 1% higher than it actually is, the same project shows a loss of nearly $1 million and is likely to be cast aside.
Nearly half the respondents to the AFP survey admitted that the discount rate they use is likely to be at least 1% above or below the company’s true rate, suggesting that a lot of desirable investments are being passed up and that economically questionable projects are being funded. It’s impossible to determine the precise effect of these miscalculations, but the magnitude starts to become clear if you look at how companies typically respond when their cost of capital drops by 1%. Using certain inputs from the Federal Reserve Board and our own calculations, we estimate that a 1% drop in the cost of capital leads U.S. companies to increase their investments by about $150 billion over three years. That’s obviously consequential, particularly in the current economic environment.
Let’s look at more of the AFP survey’s findings, which reveal that most companies’ assumed capital costs are off by a lot more than 1%.
See how terminal value growth assumptions affect a project’s overall value with the interactive tool: What is Your Cost of Capital?
The miscalculations begin with the forecast periods. Of the AFP survey respondents, 46% estimate an investment’s cash flows over five years, 40% use either a 10- or a 15-year horizon, and the rest select a different trajectory.
Some differences are to be expected, of course. A pharmaceutical company evaluates an investment in a drug over the expected life of the patent, whereas a software producer uses a much shorter time horizon for its products. In fact, the horizon used within a given company should vary according to the type of project, but we have found that companies tend to use a standard, not a project-specific, time period. In theory, the problem can be mitigated by using the appropriate terminal value: the number ascribed to cash flows beyond the forecast horizon. In practice, the inconsistencies with terminal values are much more egregious than the inconsistencies in investment time horizons, as we will discuss. (See the sidebar “How to Calculate Terminal Value.”)
Having projected an investment’s expected cash flows, a company’s managers must next estimate a rate at which to discount them. This rate is based on the company’s cost of capital, which is the weighted average of the company’s cost of debt and its cost of equity.
Estimating the cost of debt should be a no-brainer. But when survey participants were asked what benchmark they used to determine the company’s cost of debt, only 34% chose the forecasted rate on new debt issuance, regarded by most experts as the appropriate number. More respondents, 37%, said they apply the current average rate on outstanding debt, and 29% look at the average historical rate of the company’s borrowings. When the financial officers adjusted borrowing costs for taxes, the errors were compounded. Nearly two-thirds of all respondents (64%) use the company’s effective tax rate, whereas fewer than one-third (29%) use the marginal tax rate (considered the best approach by most experts), and 7% use a targeted tax rate.
This seemingly innocuous decision about what tax rate to use can have major implications for the calculated cost of capital. The median effective tax rate for companies on the S&P 500 is 22%, a full 13 percentage points below most companies’ marginal tax rate, typically near 35%. At some companies this gap is more dramatic. GE, for example, had an effective tax rate of only 7.4% in 2010. Hence, whether a company uses its marginal or effective tax rates in computing its cost of debt will greatly affect the outcome of its investment decisions. The vast majority of companies, therefore, are using the wrong cost of debt, tax rate, or both—and, thereby, the wrong debt rates for their cost-of-capital calculations. (See the exhibit “The Consequences of Misidentifying the Cost of Capital.”)
Errors really begin to multiply as you calculate the cost of equity. Most managers start with the return that an equity investor would demand on a risk-free investment. What is the best proxy for such an investment? Most investors, managers, and analysts use U.S. Treasury rates as the benchmark. But that’s apparently all they agree on. Some 46% of our survey participants use the 10-year rate, 12% go for the five-year rate, 11% prefer the 30-year bond, and 16% use the three-month rate. Clearly, the variation is dramatic. When this article was drafted, the 90-day Treasury note yielded 0.05%, the 10-year note yielded 2.25%, and the 30-year yield was more than 100 basis points higher than the 10-year rate.
In other words, two companies in similar businesses might well estimate very different costs of equity purely because they don’t choose the same U.S. Treasury rates, not because of any essential difference in their businesses. And even those that use the same benchmark may not necessarily use the same number. Slightly fewer than half of our respondents rely on the current value as their benchmark, whereas 35% use the average rate over a specified time period, and 14% use a forecasted rate.
The next component in a company’s weighted-average cost of capital is the risk premium for equity market exposure, over and above the risk-free return. In theory, the market-risk premium should be the same at any given moment for all investors. That’s because it’s an estimate of how much extra return, over the risk-free rate, investors expect will justify putting money in the stock market as a whole.
The estimates, however, are shockingly varied. About half the companies in the AFP survey use a risk premium between 5% and 6%, some use one lower than 3%, and others go with a premium greater than 7%—a huge range of more than 4 percentage points. We were also surprised to find that despite the turmoil in financial markets during the recent economic crisis, which would in theory prompt investors to increase the market-risk premium, almost a quarter of companies admitted to updating it seldom or never.
The final step in calculating a company’s cost of equity is to quantify the beta, a number that reflects the volatility of the firm’s stock relative to the market. A beta greater than 1.0 reflects a company with greater-than-average volatility; a beta less than 1.0 corresponds to below-average volatility. Most financial executives understand the concept of beta, but they can’t agree on the time period over which it should be measured: 41% look at it over a five-year period, 29% at one year, 15% go for three years, and 13% for two.
Reflecting on the impact of the market meltdown in late 2008 and the corresponding spike in volatility, you see that the measurement period significantly influences the beta calculation and, thereby, the final estimate of the cost of equity. For the typical S&P 500 company, these approaches to calculating beta show a variance of 0.25, implying that the cost of capital could be misestimated by about 1.5%, on average, owing to beta alone. For sectors, such as financials, that were most affected by the 2008 meltdown, the discrepancies in beta are much larger and often approach 1.0, implying beta-induced errors in the cost of capital that could be as high as 6%.
The next step is to estimate the relative proportions of debt and equity that are appropriate to finance a project. One would expect a consensus about how to measure the percentage of debt and equity a company should have in its capital structure; most textbooks recommend a weighting that reflects the overall market capitalization of the company. But the AFP survey showed that managers are pretty evenly divided among four different ratios: current book debt to equity (30% of respondents); targeted book debt to equity (28%); current market debt to equity (23%); and current book debt to current market equity (19%).
Because book values of equity are far removed from their market values, 10-fold differences between debt-to-equity ratios calculated from book and market values are actually typical. For example, in 2011 the ratio of book debt to book equity for Delta Airlines was 16.6, but its ratio of book debt to market equity was 1.86. Similarly, IBM’s ratio of book debt to book equity in 2011 stood at 0.94, compared with less than 0.1 for book debt to market equity. For those two companies, the use of book equity values would lead to underestimating the cost of capital by 2% to 3%.
Finally, after determining the weighted-average cost of capital, which apparently no two companies do the same way, corporate executives need to adjust it to account for the specific risk profile of a given investment or acquisition opportunity. Nearly 70% do, and half of those correctly look at companies with a business risk that is comparable to the project or acquisition target. If Microsoft were contemplating investing in a semiconductor lab, for example, it should look at how much its cost of capital differs from that of a pure-play semiconductor company’s cost of capital.
But many companies don’t undertake any such analysis; instead they simply add a percentage point or more to the rate. An arbitrary adjustment of this kind leaves these companies open to the peril of overinvesting in risky projects (if the adjustment is not high enough) or of passing up good projects (if the adjustment is too high). Worse, 37% of companies surveyed by the AFP made no adjustment at all: They used their company’s own cost of capital to quantify the potential returns on an acquisition or a project with a risk profile different from that of their core business.These tremendous disparities in assumptions profoundly influence how efficiently capital is deployed in our economy. Despite record-low borrowing costs and record-high cash balances, capital expenditures by U.S. companies are projected to be flat or to decline slightly in 2012, indicating that most businesses are not adjusting their investment policies to reflect the decline in their cost of capital.
With $2 trillion at stake, the hour has come for an honest debate among business leaders and financial advisers about how best to determine investment time horizons, cost of capital, and project risk adjustment. And it is past time for nonfinancial corporate directors to get up to speed on how the companies they oversee evaluate investments.
View the original article in The News and Observer by clicking here.
Can business have a higher purpose than profits and revenues? Should business have a higher purpose than profits and revenues?
Michael Jacobs spoke with AFP Conversations host Ira Apfel about corporate governance, business with a higher purpose, and how treasury and finance fits into this equation.
View the original article in The News and Observer by clicking here.
Six proposed constitutional amendments are on the ballot. Two are controversial within the Republican Party, which authored them. One shifts the power to nominate members of the state Board of Elections and Ethics to the legislature (the governor would choose from a list provided by the legislature); the other gives the legislature a role in filling judicial vacancies.
If I had not chaired a commission that was at the vortex of former Gov. Pat McCrory’s blitzkrieg to preserve executive powers, I would vote differently on the Board of Elections amendment. Having served in the executive branch in Washington for President George H.W. Bush, my inclination would be to leave things the way they are. But my experience in North Carolina is testimony as to why a single person, with tentacles in political matters that can impact them personally, should not control independent boards and commissions.
In 2014, Gov. McCrory appointed me chairman of the N.C. Coal Ash Management Commission, not an enviable position. It is a role I did not seek and accepted entirely as public service.
The legislature created the Coal Ash Commission to save the governor from himself. McCrory had spent essentially his entire career working for Duke Energy; he was clearly not the person to oversee what was projected to be up to a $10 billion initiative that had the potential to significantly impact Duke’s financial stability and stock price.
So lawmakers created an independent commission of nine people to oversee the cleanup process. The House and Senate were each allotted three seats, as was the governor, who had the authority to select the commission chair.
The night before the commission’s first meeting, in a strategically timed legal maneuver, McCrory filed a lawsuit against the commission and the six commissioners he did not appoint, seeking to abolish the Coal Ash Commission and two other commissions.
During the time the Coal Ash Commission existed, I never once got the sense the governor’s motivation was good governance. His handlers seemed to be driven by a desire to manage a politically explosive issue, given the reelection campaign on the horizon. The Dan River spill had been a featured story on 60 Minutes, and coal ash was McCrory’s greatest vulnerability (until his ill-fated embrace of HB2.)
It was clear the governor’s office wanted to control — not support — the “independent” commission from the start. They offered up someone from the Department of Public Safety, who didn’t know the first thing about the subject matter, to be my chief of staff. Instead, I selected a very highly regarded member of the state Department of Environment and Natural Resources staff who was a former student of mine; I knew she would do a superb job of managing the Commission staff and interfacing with Duke and DENR.
Then I chose as my general counsel a talented lawyer who had previously worked in the environmental section of the Attorney General’s office. She was extremely well respected and trusted by environmental groups, who were a key stakeholder.
I asked each of the six commissioners appointed by the legislature which lawmaker had sponsored them and what expectations, if any, had been communicated. To a person, every commissioner said they were not selected with any conditions whatsoever.
The commissioners and staff were both independent and competent. Over the 18 months the commission existed, we received full support and cooperation from Duke Energy, most environmental groups, and the legislature, but not from the governor’s office. Commissions and boards that are supposed to be independent should not be under the thumb of a single individual.
View the original article in The News and Observer by clicking here.
I recently spoke to the UNC College Republicans. Both of them.
Seriously, there is a robust group of students in Chapel Hill who are willing to be identified as non-progressives on what has become an overwhelmingly progressive campus. Though a majority of today’s college students believe (and are often being taught) that socialism is a superior economic model to capitalism, chances are that half of UNC students come from homes where at least one of their parents votes Republican.
I asked the young Republicans if they ever felt that answering a test question or paper assignment honestly–rather than appealing to the political bias of their professor–would cause them to receive a lower grade. All but two out of about 40 students in attendance raised their hands.
I knew the answer. My son was chairman of the UNC College Republicans 4 years ago, and the Phillips Exeter Republicans before that. I have had dozens of students, interns, teaching assistants, another son, and children of many friends tell me the same.
Last semester I created a new course, “Business, Politics and Public Policy,” for UNC’s GLOBE program, which is an elite group of 53 students with approximately equal numbers from Copenhagen Business School, Chinese University of Hong Kong, and UNC. On the first day of class, I had them fill out an anonymous survey on a variety of topics.
Among the questions was the same one I posed to the UNC College Republicans. Naturally, the group with the largest percentage answering in the affirmative that professor political bias influenced their answers to tests and papers was the cadre from UNC, more than the other two groups combined.
I was recently chatting with a state senator and graduate of UNC, who relayed a story to me involving a close family friend. The girl was a freshman at Carolina this fall. She made a statement in an English class that reflected a conservative viewpoint, and the other students pounced on her in an attempt to shame her for not walking the progressive line. The teacher allowed the verbal abuse to go on unchecked for some time, to the point that the young woman called her parents in tears that night and pleaded to transfer to a school with a less hostile political culture.
One of my top MBA students, who I would categorize as moderate, recently told me that she will no longer participate in class discussions that involve social or political issues for fear of being branded by the “progressive police.”
This is a disgrace; and antithetical to a classic “liberal” education whereby students are supposed to be taught critical thinking. Is there any wonder why so many North Carolina citizens, our legislature, and the Board of Governors are fed up with the political indoctrination occurring at taxpayer-funded educational institutions?
Given today’s toxic political discourse, professors who teach classes that address social, religious or political topics should be required to honor a pledge to respect the viewpoint of all students, and to create an atmosphere where thought diversity is encouraged, not shamed or punished. Students should be informed of this ground rule, and there should be an accountability mechanism to report violations.
Sadly, even well-intended university leaders are “captured” by the political monoculture on college campuses. Administrators turn a blind eye to political discrimination, a cancer that is destroying higher education. Any attempt to promote thought diversity among the faculty, unlike the countless other diversity initiatives, is condemned as a violation of academic governance norms.Chancellors who lack the backbone to demand respect for viewpoint diversity among the faculty and students should be replaced.
View the original article in The News and Observer by clicking here.
Racism is often easy to spot. When a cab driver fails to stop for a black person; when Jews were recently spit upon while walking in a Muslim neighborhood in France; when Muslims are assumed to be terrorists.
But most racism is more subtle. And often those who shout the loudest about racial bias are guilty of discrimination themselves.
As I have documented in the past, the only two significant counties in North Carolina that lost black population the last decade are homes to Chapel Hill and Asheville, the two most progressive communities in the state.
Are policies that restrict construction of new homes in low-cost rural areas—forcing the gentrification of in-town black neighborhoods—racist? Is the fact that the Asheville and Chapel Hill school districts consistently have the highest disparity between the test scores of blacks and whites a sign of racism?
Is spending a fortune on educating children in Mandarin, a curriculum seldom chosen by black and Hispanic children, rather than addressing the racial academic performance gap, a subtle form of racism? Does banning from your city limits the most popular retailer for low-income residents to buy their groceries send a message that certain people are not welcome?
Harvard political scientist Ryan Enos looked at how whites in Sen. Elizabeth Warren’s backyard behave when minorities appear in their homogeneous communities. As reported in The New York Times, Enos published a book titled “The Space Between Us,” suggesting that “the ideological commitment of liberals in these and other similar communities may waver, or fail entirely, when their white homogeneity is threatened….Enos demonstrates that the liberal resolve of affluent Democrats can disintegrate when racially or ethnically charged issues like neighborhood integration are at stake.”
The experiment Enos ran consisted of injecting Spanish-speaking people into commuter train stations located in upscale Anglo suburban communities outside of Boston. The local population had an average income of about $150,000; 88 percent had college degrees. These communities rejected “racist” Donald Trump by margins ranging from 25-50 percent.
In his 2014 paper published by the National Academy of Sciences, Enos describes his study in detail. His basic conclusion was: “The good liberal people catching trains in the Boston suburbs became exclusionary…..Exposure to two young Spanish speakers for just a few minutes, or less, for just three days had driven them toward anti-immigration policies associated with their political opponents.”
Recently, after the Seattle city council had unanimously voted to impose a special tax on large local companies to fund more affordable housing, the social justice-minded Seattle business community revolted. Members of the community were getting into shoving matches in the grocery store over the divisive policy. Immediately, the city council reversed direction and repealed the tax with only two dissenters sticking to their guns.
It is easy to denounce discrimination, and to promote social justice, when it does not impact your life personally. I will never forget being told by a member of the Chapel Hill Town Council that he had just come from eating lunch at a pizza restaurant in the rural part of the county, and that he “didn’t know there were people like that in our community.”
Discrimination is not just racial in origin. New York Times columnist Nicolas Kristof quoted an African-American university professor who said that in society he felt discriminated against because of his skin color, but on the college campus he was discriminated against because he was a Christian.
Before we accuse others of discrimination, perhaps we all need a long look in the mirror.